Regulator Focus on Insurance Woes May Help Credit Risk Management

More private insurers are pulling coverage and withdrawing from property and casualty markets they deem high risk, presenting the banking industry with a new set of potential risks. If certain collateral were suddenly impossible to insure, banks would find property lending perilous or even untenable in those affected markets. “It’s a dealbreaker,” said Matt Bryant, an executive vice president and director of credit risk at Frost Bank, of lending against potentially uninsurable assets.   

Climate-related factors are, at least in part, behind the insurance industry’s retrenchment. Major insurers including State Farm and Allstate are exiting some homeowners insurance markets or have stopped writing new policies because of costs related to increasingly frequent and destructive weather events. “This trend feeds off itself,” said David Carlin, founder of the sustainability firm Cambium Global Solutions. “What you get is a ‘circling-the-drain’ effect as climate risks rise and insurers exit the market. We mistakenly assume that [the insurance market] is a dynamic safety net that will always be there.” 

State and federal regulators recognize the growing risks of insurance availability and affordability, and weather’s potential effect on financial services writ large. President Joe Biden’s 2021 Executive Order mandating federal action on climate-related financial risk charged the Federal Insurance Office (FIO)— the only federal entity whose mandate is to monitor the insurance industry at a national level—with assessing gaps in the regulation and oversight of insurers related to climate. In June 2023, the FIO issued a report outlining its initial findings: 

• Climate-related risks—including physical, transition, and litigation risks—present new and increasingly significant challenges for the insurance industry. Oversight is an increasingly critical topic for state regulators. 
• State regulators and the National Association of Insurance Commissioners (NAIC) are doing more on climate-related risk, but in most cases, efforts are at the preliminary stage. 
• Current regulatory frameworks offer tools state regulators can adapt to better consider climate-related risks, which some are already doing. 
• All state insurance regulators should prioritize efforts to adapt regulatory and supervisory tools to consider climate-related risks. 
• More work is needed at the federal and state levels, and in the research and private sectors, to better understand the nature of climate-related risks and their implications for insurers.  

States’ responses to climate-related issues in their home insurance markets have varied, though the NAIC—an industry group comprising states’ insurance regulators—has established a task force to coordinate the response among state regulators, industry, and other stakeholders on climate-related risk and resiliency issues. 

For Now, a FAIR Solution to Insurance Availability 

The FIO and state regulators recognize that it’s still early days in finding an enduring solution to the climate-related stressors in the property and casualty insurance industry. Even identifying them all is a challenge. For now, state-mandated insurance programs are often acting as insurers of last resort in the property and casualty markets when other private insurance options are unavailable. 

More than two-thirds of states require the private insurers operating within their states to backstop the property and casualty insurance market under Fair Access to Insurance Requirements (FAIR) plans, which spread around the risk by pooling underwriting among several insurers, who fund the plans. In 1968, California was among the first states to establish a FAIR plan in the wake of devastating brush fires and a period of deep civil unrest.  

Today, requirements among states’ FAIR plans vary, but typically homeowners deemed “high risk”—due to severe weather exposure, high crime, or a property’s structural issues—can qualify only after they’ve been rejected for insurance by private carriers. The number of rejections required varies by state. Qualifying typically also depends on homeowners upgrading their properties to make them more structurally resilient. 

Over the past decade, the amount of exposure underwritten in these policies has almost doubled, to $837 billion from $445 billion, owing in part to the rise in property prices and replacement costs.  

Concerned about the risk in and solvency of these plans, states including Florida are working to push participants back to the private markets through legislative action. The state recently passed “depopulation” legislation incentivizing private insurers through cash payments to offer FAIR participants coverage and move them off the FAIR ranks. 

As of March 2022, more than 10% of Florida homeowners had multi-peril insurance coverage through the state’s FAIR plan sold through Citizens Property Insurance, according to data published by the state’s insurance regulator; a year later, more than 18% of homeowners were on the FAIR plan. According to information provided on the Citizens website, the number of policies it issued has surged past 1.2 million as of July 1. 

In California, 65,500 residents signed up for FAIR plan insurance during the fiscal year ended September 2022, the state reported. Through the first six months of fiscal year 2024 (ending March), 73,839 signed up, more than double the 2022 rate. 

While FAIR plans address some of the challenges of insurance availability among high-risk property occupants, they don’t necessarily address the affordability of insurance. FAIR plans were not designed as a solution for low-income residents, but rather to ensure insurance is available when private policies aren’t. Though limited data exists comparing FAIR premiums to those of private insurers, many insurance experts agree that FAIR plan premiums are substantially higher.  

High premiums on private market insurance can strain consumers’ ability to service personal debt, such as mortgages. While what’s covered varies from state to state, according to May 2024 data from insurance.com, for $300,000 of dwelling and liability coverage with a $1,000 deductible, Oklahoma is the most expensive state for homeowners insurance at $5,858 per year, followed by Kansas at $4,843 per year. Hawaii, at $613, is the least expensive.  

Evaluating insurance affordability’s contribution to credit risk is, in the end, part of banks’ normal assessment process. Predicting the ongoing availability of collateral insurance is also a credit risk management exercise, but it creates a whole different set of challenges in determining lendability and risk weightings. “Higher insurance costs are exposing relationship managers to borrowers that may not be as good as we thought,” Bryant said. “Fear that they won’t find insurance on collateral is also credit risk. Picking the right client at origination is always important.” 

As more insurers exit homeowners insurance markets or decline to renew existing policyholders, banks will need to step up their vigilance over insurance coverage and tracking insurance certificates on the collateral behind their loans. Among the steps banks can take is installing software to monitor coverage and notify borrowers of renewal dates, and insuring themselves against exposure from borrowers’ lapsed policies.